ECONOMIC

SYSTEMS
Chapter 2
Section 1

ANSWERING THE THREE

ECONOMIC QUESTIONS
THE THREE ECONOMIC QUESTIONS

 As a result of scarce resources, societies must answer

three key economic questions:
 What goods and services should be produced?
 How should these goods and services be produced?
 Who consumes these goods and services?

 How a society answers these three questions defines

the type of economic system that society has.
QUESTIONS 1 & 2

 What goods and services should be produced?

 Each society must decide what to produce in order to satisfy the needs and
wants of its people.
 Because resources are limited, each decision that a society makes about
what to produce comes at an opportunity cost.

 How should goods and services be produced?

 As a society decides how to produce its goods and services, it must
consider how best to use its land, labor, and capital.
QUESTION 3

Who consumes goods and services?

 This question is largely determined by how societies distribute

income.
 Through factor payments, including profits, societies can determine
who will be the consumers of the goods and services produced.
ECONOMIC EFFICIENCY

 Societies answer the three economic questions based on

the importance they attach to various economic goals.

 Because resources are always scare, societies try to

maximize what they can produce using the resources they
have.
 If a society can accurately assess what to produce, it increases economic
efficiency.
 Economic Goals
Economic efficiency: Making the most of resources
Economic freedom: Freedom from government intervention in the
production and distribution of goods and services
Economic security & Assurance that goods and services will be available,
predictability: payments will be made on times, and a safety net will
protect individuals in times of economic disaster
Economic equality: Fair distribution of wealth
Economic growth & Innovation leads to economic growth, and economic
innovation: growth leads to a higher standard of living
Other goals: Societies pursue additional goals, such as environmental
protection
All nations must prioritize their economic goals, or
arrange them in order of importance. No matter
how a nation prioritizes its goals, one fact remains:

Achieving any economic goal comes with some

kind of economic trade-off
 ECONOMIES AND VALUES
Type of Economy Characteristics

Traditional: • Relies on habit, custom, or ritual to decide what to produce, how to

produce it, and whom to distribute it to
• Little room for innovation and change
• Revolves around the family; work divided among gender lines
Market: • Economic decisions made by the individual; based on exchange
(trade)
• The choices made by individuals determine what gets made and how,
as well as who consumes the goods & services produced
• Also called free markets (or capitalism)
Command: • Central government alone decides how to answer all 3 questions
• Sometimes called centrally planned economies– a central authority is
in command of the economy
Mixed: • Most modern economies are mixed
• Market-based systems in which the government plays a limited role
Section 2

THE FREE MARKET

THE FREE MARKET

What do a farmer’s market, a sporting goods

store, the New York Stock Exchange, and the sign
you posted on your community bulletin board
advertising baby-sitting services have in common?

They are all examples of markets!

WHY DO MARKETS EXIST?

 Markets, like a farmer’s market, a sporting goods store, and

the New York Stock Exchange, eliminate the need for any
one person to be self-sufficient.
 Markets allow us to exchange the things we have for the
things we want.
THE FREE MARKET

What are the characteristics of a free market

economy?
 A free market economy is characterized by:
 Households and firms
 Factor and product markets
 Self-interest
 Competition
 Economic freedom, efficiency, and equity
SPECIALIZATION
 Rather than being self-sufficient, each of us specializes
in a few products or services.
 Specialization leads to efficient use of land, labor,
and capital.
 Specialization allows businesses to focus on a limited number
of related products or services.

 Because of specialization, markets are needed to give

people an arena with which to sell their products and
to buy products that they don’t produce themselves
but need.
FREE MARKET ECONOMY
 In a free market, answers to the three key economic
questions are made by voluntary exchange in the
marketplace.

 Choices made by individuals determine what gets made,

how it is made, and how much people can consume of the
goods and services produced.

 In a free market system, individuals and privately owned

businesses own the factors of production.
CIRCULAR FLOW MODEL OF A MARKET
ECONOMY
FACTOR AND PRODUCT MARKETS

 In an arena of exchange known as the factor market, firms

purchase factors of production, such as renting land, hiring
and paying workers, and borrowing money, from
households.

 The arena in which households buy the goods and services

that firms produce is called the product market.
SELF-REGULATING NATURE OF THE
MARKET PLACE
How is it that firms and households cooperate
to give each other what they want– factor
resources (in the case of firms) and products
(in the case of households)?

 Self-Interest
 Competition
 The “Invisible Hand”
SELF-INTEREST

In The Wealth of Nations, Adam Smith observes that

in the countless transactions that occur in the
market, the buyer and seller consider only their
self-interest.

 Self-interest is the motivating force in the free market.

 Consumers pursuing their self-interest have the
incentive to look for lower prices.
COMPETITION
 Consumers (households), in pursuit of their self-interest, have the
incentive to look for lower prices
 Incentives are the hope of reward of fear of punishment that encourages a person to
behave in a certain way
 Firms (businesses) seek to make greater profits by increasing sales
 Ex, Shirt manufacturer making striped versus polka dot shirts

 Economists call the struggle among producers for the dollars of

consumers competition
 While self-interest is the motivating force behind the free market,
competition is the regulating force
 THE “INVISIBLE HAND”
 Self-interest and competition work together to regulate the marketplace
 Self-interest spurs consumers to purchase certain goods & services and firms to produce
them
 Competition causes more production and moderates firms’ quests for higher
prices
 Overall result is consumers get the products they want at prices that closely
reflect the cost of producing them
 All of this occurs without any central plan or direction

 Adam Smith called this phenomenon “the invisible hand of the marketplace.”
ADVANTAGES OF THE
FREE MARKET
Under ideal conditions, free
market economies meet the
following economic goals:
• They respond to rapidly
changing conditions.
• They have a large degree
of economic freedom.
• They encourage
economic growth.
• They lend themselves to
consumer sovereignty.
Section 3

CENTRALLY PLANNED
ECONOMIES
CENTRALLY PLANNED ECONOMY
 A centrally planned economy is characterized by:
 Government answering the three economic questions
 Government ownership of land, labor, and capital
 Opposition to private property, free market pricing,
competition, and consumer choice
 In a centrally planned economy (also known as a
command economy), the government, rather than
individual producers and consumers, answer the key
economic questions.
 The government owns both land and capital.
 The government also controls where people work and what
they are paid.
COMMAND VS. FREE MARKET

Command economies operate in direct contrast to

free market systems.

Command economies oppose:

 Private property
 Free market pricing
 Competition
 Consumer choice
SOCIALISM
 The term socialism describes a range of economic and
political systems based on the belief that wealth should be
evenly distributed throughout society.

 Socialists argue that economic equity can only exist if the

centers of economic power are controlled by the
government or by the public as a whole, rather than by
individuals or corporations.
COMMUNISM
Under communism, the central government owns
and controls all resources and means of
production.
 Communism derived from the writings of Karl Marx
who believed that labor was the source of all value but
that under capitalism, all the profit created by laborers
ended up in the hands of the property owners.
 The inevitable cost of capitalism according to Marx was
the exploitation of workers and an unfair distribution of
wealth.
THINK OF EXAMPLES OF FORMER OR
CURRENT COMMUNIST AND
SOCIALIST NATIONS.
DISADVANTAGES
 Nations with command economies often have trouble
meeting the basic economic goals.
 The complex bureaucracy of a command economy is not
efficiently run and does not adjust quickly to market changes.
 There is minimal, if any, economic freedom.
 Innovation is not rewarded and thus economic growth is
stilted.
 There is no economic equity.

 However, command economies do guarantee jobs and

income and can be used to jump-start selected industries.
Section 4

MODERN ECONOMIES
MIXED ECONOMIES

A mixed economy is characterized by:

 A market-based economy with some government
intervention
 Government helps societies meet needs that would be
too difficult for them to meet under a totally free
market economy, such as education
 Government protects property rights and ensures that
exchanges in the marketplace are fair
THE RISE OF FREE MARKETS
Even free market thinkers like Adam Smith
recognized the need for a limited degree of
government involvement in the economic
marketplace.
In a mixed economy, the market is free but has a
certain degree of government control.
The government:
 Provides national defense and public education
 Protects private property
 Ensures fair exchanges in the marketplace
CIRCULAR FLOW MODEL OF A MIXED
ECONOMY
COMPARING ECONOMIC SYSTEMS

Most modern economies are mixed economies.

 The figure below shows a continuum of mixed
economics in today’s world.
GOVERNMENT INTERVENTION IN THE U.S.

The American government intervenes in the

economy by:
 Keeping order
 Providing vital services
 Promoting general welfare

Federal and state laws protect private property.

 The marketplace operates with a limited degree of government
regulation.
AMERICAN ECONOMIC FREEDOM

 The United States enjoys a high

level of economic freedom.
 Foreign investment and free
trade is encouraged
 The banking industry operates
under relatively few
restrictions
 Foreign-owned banks have few
additional restrictions